So you're hoping the sale of your business will finance your retirement someday

by Charles Bosler, CPA, MBA, ABV

No one finds out what it takes to successfully compete in today’s world more thoroughly than the business owner. Public servants do not, as public money will roll in tomorrow to fund their existence regardless of how efficient their decisions are today. Corporate employees do not, as their piece of the big picture is rarely as big as the business owner’s, and only their income is at stake based on their performance, not so much on their reputation and significant amounts of their invested capital.

We all know that we have to compete once reaching the age of reason, but few have to excel in as many areas as the business owner. Areas which must be mastered include sales and marketing, operating at top efficiency, technological advancement as it applies to all aspects of the business, human relations, billing, collections, and other organizational disciplines. The business owner must be especially good in most all of these areas if he expects to grow over the long term. In order to have a chance at financial success, a business must first be headed by one or more persons who are better than average at what they do. After all, how could a business thrive very long amongst competition offering better consumer choices? Anyone succeeding over the long term in the capacity of running their own business has reason to be proud. They did it their way and must have been better than average in the effort. Otherwise, the competition would have edged them out. Indeed, most people are not up for this level of challenge to the extent they will put their financial livelihoods and that of their family’s on the line.

One would think that if he or she nurtured a business for many years and proved its ability to compete in today’s world, they should be able to count on the sale of that business for a good part of their retirement funds. Yet the following statistics taken from the 2001 Business Reference Guide and the International Business Brokers Association imply otherwise.

Only one out of three large businesses put on the block during 2001 actually sold. For smaller businesses, the statistics are less favorable. Only 1 out of 5.5, or 18% sold. What about the sole proprietor not having employees and therefore not included in the above table? Their equipment and ongoing customer list is undoubtedly worth something to another competitor. The agreed upon value, however, is most always dependent upon the buyer’s later success in retaining those customers. The reality is, your business might provide you with a decent livlihood for much of your career. But unless your business has the attributes in place which appeal to not just one but many likely buyers, do not bank a comfortable retirement upon the liklihood of selling to just the one, required buyer who fully appreciates your opinion of its fair market value. No buyer will have your specific talents, reputation, and network. Interested prospects will estimate the future cash flow that your business will likely provide them, not you, and the many risks that may result in worse results. If their assessment of the present value of future cash flow is notably below your asking price, most will not even counter with a lower offer.

What exactly is it that business buyers are looking for? This question should be important to business owners long before moving on to other pursuits. If not addressed until late in one’s career, statistics previously shown imply that two-thirds of even the largest privately held businesses put on the block will not receive an acceptable purchase offer in a given year. For businesses having under $750,000 in annual sales, over 80% do not receive an acceptable purchase offer. What additional hoops must the business owner jump through to realize their own opinion of fair market value when it comes time to sell? With sound advice rarely present when such thoughts surface, delay is often the easier emotional choice for many entrepreneurs to make, who identify personally with their company. But with delay, the best opportunities often come and go.

The typical business owner is readily willing to work 50% or more hours per week than the average employee to maintain the company’s profitability and reputation for reliability . Early on, it might have been a lack of working capital that caused the owner to wear many hats. Once doubts about the business being a viable going concern were removed, happiness with the status quo rarely provided continued success. The successful owner had to continue changing because the world continually changed. Long term business owners are not only survivors but usually have the wits to take many along with them. Yet when it has come time to sell, only a small minority of these owners make a convincing case that their business is worth what they think it is. After surviving so many challenges, what is it they fail to do?

Like any successful institution which has survived over generations, top management at least annually should take stock of what they have accomplished, where they are now, where they want to go, and how they plan to get there. The more organized entrepreneurs often do this in the form of written minutes to an annual meeting. Take two businesses that are equal to each other at the moment, with the exception that one is stagnant and the other is moving forward with obvious positive momentum and positive developments in the pipeline. The second business will always be worth significantly more at that point in time, as much of the value of a business comes from extrapolating its future prospects. Making sure that the business has positive momentum and developments unfolding all the time should be thoroughly addressed at least annually. A written action plan for the following year, even if in checklist form, is mandatory if you want others to be able to duplicate your success.

A businessman wanting to someday receive fair market value for his business should answer the following questions at least annually:

Question Number 1. Where are we now?

Maximizing business value begins with identifying the value components and drivers of the business as they exist today. Items enumerated might include superior service, products or processes. They might include a superior marketing plan, and/or key personnel able to accomplish much more than their peers due in part to policies and equipment in place. They might include a position of financial strength and operating efficiencies resulting from past experiences of trial and error. Additional but by no means a complete set of possible attributes as to where you are at now appears in Appendix I . Whatever these value components are, their identification will help your later plan to increase value even more.

Before completing your mostly subjective analysis of where the company is at now, make sure your analysis minimally builds on the following points of interest to prospective buyers someday:

1. Your company’s history
2. Your company’s ownership
3. Your company’s products and services
4. Your company’s customers
5. Your company’s facilities
6. Make up your company’s management
7. Make up your company’s workforce
8. Your company’s suppliers
9. Your company’s competition

On his own behalf, the business owner should also apply himself quantitatively at least annually by monitoring those financial ratios that are most applicable to his business, also measuring financial strength and weaknesses of most interest someday to prospective buyers. Such financial ratios are most often categorized in the following areas:

Liquidity Ratios
Efficiency Ratios
Profitability Ratios
Leverage Ratios
Coverage Ratios
Other Ratios

Appendix II near the end of this article more specifically describes ratios often used by bankers and investment analysts in the above categories. You should annually note how your company has performed in relation to industry averages, which are available at many public libraries. Only after periodic review of the financial ratios most applicable in measuring the financial strength and efficiency of your business, will you more clearly understand what the outsider’s conclusions will be towards the risks, cash flow, and liklihood for internal growth to be expected from your company. Constantly striving towards continued ratio improvements is the same as striving towards a higher valuation for your business someday. If you already know that the financial analysis will be favorable before the prospective buyers do their due diligence, you will find yourself in the driver’s seat when it comes time to sell.

Question Number 2. Where do we want to be?

Most prospective buyers of a business will base their maximum offering price based upon three basic components: current cash flow, current growth prospects, and currently perceived risk factors associated with the business. Accordingly, business owners will be well rewarded later if they regularly identifies the most cost efficient alternatives available to:

1. increase the Company’s cash flows
2. increase the Company’s growth rate
3. decrease in the amount of risks involved in operating the business

With respect to increasing the growth rate, growth alone does not increase the value of a business. Only growth that results in additional cash flow over and above additional working capital required to comfortably accommodate that growth, will result in an increased business valuation. Less disciplined growth pursued for growth’s sake alone often decreases the value of a business. Indeed, low margin growth can and often does result in less cash flows being generated from operations.

If you want your business to be worth more in the future then it is today, you need to widen your focus no farther than towards (a) increasing its cash flows, (b) increasing its growth rate while maintaining or improving margins, and (c ) reducing the many risks associated with your business.

Question Number 3. How do we get there?

By the time you have solidified where you are now and where you want to go, you will have many ideas about the most cost efficient options available to increase your company’s value. Policies put into place should be conducive towards fostering some combination of increasing profitable growth, increasing cash flows and reducing business risks.

Increasing Growth

There are four ways for a business to grow:

1. More marketing to increase market share
2. Develop new product lines and services
3. Buy another business entity or product line
4. Merge with another business entity.

Which is the cheaper for you to do, make or buy growth? This will essentially be a capital budgeting decision which should be easy to make. Careful analysis will lead you towards the avenue is best for you. From there, you should itemize the steps to likely succeed along the chosen avenue, and put them into effect. If you don’t put the steps into writing, do not expect growth or an increased business valuation to result.

Increasing Cash Flows

Growth is not the only way to increase cash flows. The earlier suggested ratio analysis will help you evaluate how your business stacks up in comparison to competitors. Apparent inefficiencies are an obvious starting place. The world economy is always in a phase of shifting actual production to the most cost efficient suppliers. Have you evaluated all your reasonable options to reduce labor and material costs? Are you turning your receivables over at least as fast as the competition? Is your inventory tightly monitored so as to not to unnecessarily result in waste, theft, or working capital being tied up? Yet inventory availability must still be sufficient to foster growth. Are you purchasing your inventory from the most cost effective source? What about your facilities and equipment? Could it be more efficiently configured ? Is there machinery available that could replace more expensive labor? Has the business sold off its investment in unneeded facilities and equipment, allowing capital to be put to better use?

You run your own business in part because you are more creative and energetic than the next guy. You are costing yourself money if you do not put that creativity to work on your own behalf. You should always have a strategy in place with the ultimate objective of increasing cash flows from existing operations. There are consulting firms who will help you here when you run low on your own ideas.

Reduce the Risks Surrounding Your Business

Businesses which have removed many of the uncertainties about their future cash flows always sell for greater multiples of current cash flows than higher risk operations. General Electric (GE) for instance, has long established itself as being a company which hires only the best employees available. Even then they reward only the top 80% with a graduated level of job security, bonuses, other pay increases, and benefits commensurate with their performance. GE is always introducing new products and/or delving into growing markets currently earning profit margins noticeably better than more mature product lines typically yield. GE abides by a stable debt to equity ratio which has resulted in its Triple A credit rating, a standard which implies treatment of creditors with utmost respect. Basically, investors have come to expect 15% to 20% annual growth in GE’s sales and earnings, and that is most often what they later see. As large as GE is, they still sell at a price earnings ratio most always over 20, a level usually associated with smaller growth companies. One reason is because GE has consistently shown investors in the past that they can count on steadily increased cash flows in the future. It manages and handles everyday obstacles and even the review of growth opportunities in routine manner. Law suits against it are rarely reported in the financial press, as are labor problems, despite their selective hiring policies. By making its future results very predictable, GE’s management has eliminated the perception of their being much risk about its future course and cash flow path. Its management has succeeded in achieving and then maintaining the company in a rather elite class among even the largest of companies. Minimizing business risks in many different areas had to be emphasized by its Board over many years to achieve this recognition. Investors as a result have been paying a premium for its common stock for many years.

While increased value for a business may come more rapidly from profitable growth and by increasing cash flows, generating the same level of cash flows with lower risk also creates value. In assessing vulnerability to risks, not much can be done about the over all economy effecting all businesses. Nor can management readily switch into a new industry by completely changing its customer base in a short period of time. Management, however, can work towards changing the business into a better company. The following areas are often looked at first by outsiders when assessing the level of risk associated with operations:

Access to and the cost of capital
Ownership structure and stock transfer restrictions
Company’s market share and market structure of the industry
Customer concentration
Depth and breadth of management
Distribution capability
Extent of reliance on individuals with key knowledge, skills, or contacts
Workforce competitiveness, employee relations, and reliance
Marketing and advertising capacity/efficiency
Breadth of products and services
Purchasing power and related economies of scale
Customer concentration
Vendor and supplier relations and reliance
Work force competitiveness, employer relations, and reliance
Distribution capability
Depth, accuracy, and timeliness of accounting information and internal control

High rankings in all the above areas equates into low risk operations. See Appendix I for more ideas.

You are undoubtedly able to list significant risk areas surrounding your own business to work on first. What is it most that would make your business vulnerable to uncertainty in a prospective buyer’s eyes? Improve that area and a number of less time consuming or costly areas every year. Smoother operations will result. Your business will be worth more for that reason alone.

Conclusion

As illustrated near the outset, at least two-thirds of all private businesses listed for sale do not receive an acceptable purchase offer in a year’s time. The typical business owner works hard for many years and has probably proven himself financially to be all around superior to peers in capitalizing upon opportunities that surface. When it comes time to move on, is it then time to watch the business wither away, watch past momentus efforts evaporate over a short period while competitor’s take their slice for free? Or can this same competitive businessman turn periodic, slow periods thorughout the year into a time to update his notes on where he is now, where he wants to be, and how he is going to get there. If he does not address these issues well ahead of time, all the more likely he will be cast with the majority.

Up until now, you worked hard to excell amongst your peers. Why stop short when your periodically updated, written notations now mean so much towards how your future years will be lived?

Appendix I

Identifying Valuation Components, Value Drivers and Risk Reducers

Common Value Drivers

Appendix II

Financial Ratios

Memo: For Industry Averages, refer to Robert Morris' and Associates Annual Financial Statement Studies, or other credible sources maintained by many public libraries.